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PepsiCo Inc. (NYSE:PEP)

Q3 2007 Earnings Call

October 11, 2007 11:00 am ET

Executives

Jane Nielsen - IR

Indra Nooyi - Chairman, CEO

John Compton - CEO, PepsiCo North America

Mike White - Vice Chairman, CEO PepsiCo International

Richard Goodman - CFO

Analysts

Bill Pecoriello - Morgan Stanley

Lauren Torres - HSBC

Christine Farkas - Merrill Lynch

Bonnie Herzog - Citigroup

Judy Hong - Goldman Sachs

Ann Gurkin - Davenport & Co.

Brian Spillane - Banc of America Securities

Bill Leach - Neuberger Berman, LLC

Matthew Riley - Morningstar

Alec Patterson - RCM

Robert van Brugge - Sanford Bernstein

John Faucher - JP Morgan

Kaumil Gajrawala - UBS

Operator

Good morning and welcome to PepsiCo's third quarter 2007 earnings conference call. (Operator Instructions) It is now my pleasure to introduce Ms. Jane Nielsen, Vice President of Investor Relations. Ms. Nielsen, you may begin.

Jane Nielsen

Thank you, operator and good morning, everyone. Thanks to all of you for joining us. Today's webcast includes a slide presentation that can be accessed at our PepsiCo.com website.

Before we begin, please take note of our cautionary statement. This conference call includes forward-looking statements based on our current expectations and projections about future events. Our actual results could differ materially from those anticipated in such forward-looking statements, but we undertake no obligation to update any such statements.

Please see our filings with the Securities and Exchange Commission including our annual report on Form 10-K for a discussion of specific risks that may affect our performance. You should refer to the investors section of PepsiCo's website under the heading PepsiCo Financial Press Releases to find disclosures and reconciliations of non-GAAP financial measures that may be used by management when discussing PepsiCo's financial results with investors and analysts.

This morning's prepared remarks will be made by Indra Nooyi, PepsiCo's Chairman and CEO; Mike White, PepsiCo's Vice Chairman and CEO of PepsiCo International; John Compton, CEO of PepsiCo North America; and Richard Goodman, PepsiCo's CFO. After our prepared remarks we will have time for Q&A.

I would like to call your attention to one item that affects the comparability of the numbers we reported this morning. We had a non-cash tax benefit in the quarter totaling $0.07 per share, or $115 million, related to the settlement of a tax audit in one of our international businesses. On today's call we'll refer to the results, excluding the item I just mentioned, as core results which we believe are more indicative of our ongoing performance. The net is that our core EPS grew 11% for Q3 and 14% year-to-date.

It is now my pleasure to introduce Indra Nooyi.

Indra Nooyi

Thanks, Jane and good morning, everyone. We truly appreciate the opportunity to discuss PepsiCo's third quarter results and our outlook for the balance of 2007. As you read in our press release this morning, PepsiCo continued our strong performance in the third quarter, delivering double-digit growth in revenue, division operating profits and core EPS.

With three quarters of the year now behind us, I would like to share my perspective on our business performance this year, our M&A initiatives, and the many advances we've made in our sustainability agenda. Finally, I'd like to spend a minute sharing my thoughts on our outlook for 2008, before I toss it to John Compton, Mike White and Richard who will then take you through the business segments and corporate costs in more detail.

Let me begin with business performance. I must say that I am very proud of the results our team has achieved. The powerful combination of our portfolio, the advantage business model and the complete dedication of our associates across the globe has resulted in excellent top and bottom line performance year-to-date: 10% net revenue, 10% division operating profit growth and 14% core EPS year-to-date performance.

Every division has effectively managed increased input cost inflation with a combination of pricing, mix and productivity. They've achieved in the process the right balance between consumer value and margin management.

Now, we had the benefit of a generally favorable global macroeconomic environment and a forex upside; but we have also taken the opportunity to reinvest some of our upside in order to enhance our market competitiveness, as well as to drive strong, sustainable growth.

On the acquisition front, we executed several tuck-in acquisitions. In Q3, as you read, we closed the Sandora acquisition, and in partnership with Pepsi Americas we're now the leading beverage company in the Ukraine. Most recently, we announced the acquisition of the Lucky snacks business in Brazil, and we've also built upon our successful partnerships with Unilever and Starbucks by expanding our international markets.

With the North American beverage segment, while not an acquisition, we established a relationship with Dale Earnhardt Jr. that will help us accelerate our growth in energy drinks. So far this year we have spent about a $1 billion in acquisitions, and that does not include the Lipton and the Lucky snacks deal which are still pending regulatory approvals.

Our business results and growth platforms are also enhanced by the progress we're making in our environmental sustainability agenda, reducing water and energy consumption, increasing recyclable materials in our packaging, and leading innovative carbon footprint labeling. In recognition of our efforts, I'm proud to report to you that PepsiCo retained its place on the Dow Jones Sustainability North American Index, and in September, we were added to the Dow Jones Sustainability World Index which is comprised of companies leading sustainability efforts around the world. For the balance of the year, we expect to make further progress in all three of these important areas.

Let me now turn to 2008 and briefly touch on the year coming up. I remain confident in our ability to deliver our long-term algorithm of mid single-digit volume growth, a positive spread between volume and revenue and at least 10% EPS growth.

But before I turn the call over to John Compton to discuss North America, I want to share some thoughts on the economic landscape. Clearly the acceleration of commodity prices, particularly grains, cooking oils and energy is top of mind for all of us in the food and beverage business. Domestically in North America, while commodity cost increases were slightly lower than we had forecast in the first half of this year, they've been higher than expected in the second half. For 2008, we think the second half trend will actually continue.

At this point, we are projecting North American inflation on our strategic inputs, excluding orange juice, to be more than 1 percentage point above this year's low single-digit rate, and we are expecting a similar pattern in many international markets, as well. To address this headwind, we are employing many of the same levers that have enabled us to navigate this challenge successfully over the past couple of years, namely, a combination of increased productivity, rate increases, and cross utilization through mixed management.

While we are addressing the inflation issue, we are also sensitive to the possibility of slower U.S. economic growth in the coming year. History will suggest that the nature of our product portfolio and our structural advantages will allow PepsiCo to be much more resilient than most other businesses in such circumstances; and, we clearly have a much broader global footprint than at any time in the past and we believe that our more diversified portfolio will enable us to continue to capitalize on the favorable macroeconomic climate in most of our international markets.

Nevertheless, as we move into our planning cycle for 2008, we'll be alert to the potential challenges and will be building in the necessary flexibility to adjust to changes in the overall economic environment.

In total then, I want to reiterate how pleased I am with our performance this year and how committed we are as a team to execute across our businesses with excellence and consistency going forward.

Now let me turn the call over to my good friend, John Compton, to discuss our North American business in more detail.

John Compton

Thank you, Indra and good morning, everyone. In North America we clearly made very good progress on a number of fronts in Q3. Looking across the entire portfolio, I want to particularly note our ability to manage input cost headwinds while expanding our operating margins 50 basis points. As a result, North American revenue increased almost 5%, and profit growth showed sequential improvement, achieving 7% growth in the quarter, our strongest overall profit growth this year.

Let me start first with Frito-Lay North America, our largest domestic business, which once again delivered balanced top and bottom line performance. Revenue grew a solid 6% through a combination of solid volume growth and price mix benefits of almost 4 points.

Importantly in the quarter, Frito-Lay again drove manufacturing productivity, which helped offset inflation. In total, Frito-Lay expanded operating profit margins by 25 basis points and realized 7% growth in profits. This is particularly impressive as input cost inflation accelerated on key items like cooking oil, corn and fuel.

Importantly, Frito's wins extended to the marketplace, growing both savory dollar and volume share. Volume growth drivers in the third quarter were balanced between core salty brands and Quaker snacks, with high single-digit growth in Doritos and double-digit growth in dips, multi-packs, SunChips, Stacy's and Quakes Rice Cakes.

One key element driving the continued success of the Doritos brand is sustaining the meaningful innovation. Last year's success, Blazin' Buffalo Ranch, clearly met consumer's desire for flavor intensity. The Doritos team followed that success with our recently introduced Doritos Collisions, which delivers both flavor intensity and complexity by mixing mild and spicy flavors in the same bag. Collisions is off to a terrific start.

Multi-packs offer a great portion control option and are proving increasingly successful. The package has broad appeal for moms looking for lunch box options, to boomers with smaller households looking for variety in a size that's just right for them. At the same time, one area that continued to be soft was brand Lay's where volume in Q3 was down mid single-digits, primarily as a result of the weight-up/price-up strategy implementing in the fourth quarter of last year.

We have recently taken a number of steps to address this issue. First, we have changed the packaging to a new global Lay's design. Second, we've been able to significantly expand our kettle chip offerings now that capacity is on stream, and this is particularly important given the strength of the kettle category. Soon, we will be introducing a new mid-sized line that will be more attractive to smaller households. We are encouraged by the early signs of the improvement in the business in the first few weeks of Q4.

Beyond our results, I'm proud of the progress Frito-Lay is making in reducing our usage of water and fuel, down over 30% and 20% respectively since 1999. The Jonesboro, Arkansas plant recently earned the EPA's Performance Track Program distinction for its energy conservation and waste water reductions. Net another strong, balanced quarter from the Frito-Lay team.

Turning to our beverage business, we successfully managed through a challenging summer period. In the quarter, volume was down 1%; revenues though were up 3% and profit grew 7%, our strongest profit growth of the year. All of us recognize that a 1% volume decline is not in line with our expectations for this business. However, as a number of you noted in your reports, the months of June and July were unseasonably cool and rainy and had an impact across all beverages, particularly Gatorade. Fortunately, August returned to normal -- in fact, a few degrees hotter than the previous year and the business in total responded, driven by Gatorade. It's encouraging to see the positive momentum in the Gatorade business continuing through September.

Now starting with our hydration brands, our water portfolio grew high single-digits led by double-digit growth in Propel and SoBe Lifewater. Gatorade did decline mid single-digits in the quarter but as I said, exited with strength. That strength is continuing in Q4, consistent with our long-term guidance of high single-digit growth.

Looking forward, we have exciting news across these brands that will set the stage for Q4 and beyond. Let me take a minute to take you through some of the new product launches that we believe will fuel significant incremental growth.

At the heart of our effort to restore high single-digit growth to the Gatorade trademark is the launch of G2. G2 is a low calorie, electrolytic beverage with just 25 calories per eight-ounce serving; half the calories of Gatorade, but with all the electrolytes. It expands the Gatorade product line to now meet the hydration needs of athletes on a 24/7 basis.

Equally important, Propel is introducing a new line extension, Propel Invigorating water. This fitness water from Propel is mildly caffeinated and lightly flavored with only 20 calories per 8-ounce serving. It's designed to not only hydrate and nourish, but to also provide a boost for active people throughout the day.

Additionally, we are relaunching SoBe Lifewater. SoBe Lifewater is being reformulated with sucrose -- which as you know, is table sugar -- antioxidants, vitamins and natural herbs. Each flavor will have a unique blend of ingredients offering a distinct benefit. SoBe Lifewater's new formulation will have lower calories than before and fewer than our competitors. At the same time, we are leveraging our bottler's distribution power in select channels and packages to maximize the availability of G2 and the entire Propel line.

Turning to CSDs, we gained volume and value share in the quarter. However, the category as a whole continued to suffer volume declines and our own CSD volume fell 3%, led by declines in trademark Pepsi. At the same time, innovation did drive growth in certain segments as Mountain Dew, Game Fuel and Diet Pepsi Max each gained a half a share point in Period 9. Game Fuel's unique linkage with Microsoft Xbox launch of Halo 3 connected with target consumers and enabled trademark Mountain Dew to deliver positive growth in the quarter.

Beyond CSDs, the strong momentum of our ready-to-drink teas continued with growth over 20% and significant gains in both volume and value share. Energy also posted over 20% growth, led by an almost 70% increase in Mountain Dew AMP. As we noted on the second quarter call, we are increasingly focused on the AMP brand and will turbocharge our performance in 2008 as we leverage our relationship with NASCAR legend Dale Earnhardt, Jr., who will drive the number 88 car with Mountain Dew AMP as the lead sponsor.

Our portfolio of juices and juice drinks continued on track, realizing net revenue gains to offset significant inflation. In our recently acquired Naked Juice business, we just introduced the first 100% juice smoothie with probiotics, which as you know, aid in digestive and immune health. Tropicana will be extending its Pure line in early Q1 which we believe will fuel growth in 2008.

Overall in beverages with our powerful brands, with great innovation and our strong growth go-to-market systems, we will finish the year with accelerated momentum that will carry into the coming year.

Turning to Quaker Foods North America, the division reported 2% revenue and 2% NOBIT growth, about in line with our expectations. The 2% volume decline, in part, reflected price increases to cover inflation in key raw materials and in part, shipment timing. The fall product rollout was in Q3 last year and is in Q4 of this year. In terms of innovation, we are very encouraged by the strong early results in the launch of Simple Harvest, which moves the Quaker trademark beyond oats to multiple grains.

All in all, I am very pleased with our performance in North America. Going forward we expect Frito-Lay to remain strong and our beverage portfolio is now primed for growth.

Let me now turn the call over to Mike White.

Mike White

Thanks very much, John and good morning, everyone. The underlying fundamentals for PepsiCo International also remain very strong, enabling us to deliver another terrific quarter with revenues up 22% and our operating profits up 19%.

Importantly, I think we had solid volume and market share growth across both our snacks and beverage categories. We obviously continue to benefit from a favorable macroeconomic climate internationally, and especially in emerging markets. However, many of our markets are also managing the rising inflationary pressures that are impacting our North American colleagues. We have seen this most particularly in Mexico where corn, wheat and cooking oils have all increased in price significantly this year.

Clearly too, both the reported revenue and operating profit growth reflected the benefit of some forex upsides as well as M&A and so I thought I would take a moment just to put our financial results into the appropriate context for you.

First, in addition to the acquisition of the Bluebird snacks business in New Zealand and the divestiture of the Sugar Puffs cereal business in the UK, our third quarter results were impacted by our increased equity ownership in several of our beverage joint ventures in China, as well as the buyout of our joint venture partner in a snacks JV encompassing several Central American countries. Now in the past, we reported no revenues and only our share of net income for those joint ventures. Now we're consolidating the revenues as well as the profits; reporting all the revenue, as well as our increased share of the profits.

Now the impact of full revenue consolidation plus the creation of our Russia joint venture with PBG and some year one integration costs are the primary reasons that total M&A activity added 7 full points to revenue growth, but had minimal impact on operating profit growth for the quarter. By the way, this also accounted for more than 100% of PI's reported operating margin decline in the third quarter. In fact, excluding the impact of all these M&A activities, margins improved by almost 50 basis points in the quarter, which is right in line with the expectations I've had and previously have communicated to you for our business.

Second, although forex tailwinds added 6 points of revenue and operating profit in the quarter, we made a conscious decision to reinvest a portion of that upside in the third quarter and will be continuing to further reinvest in selected strategic markets in fourth quarter as well.

Third, as you saw in the press release, there was a combination of several other items: some lower amortization expenses and higher costs related to the international SAP implementation, and a few favorable items from 2006 that we were lapping which in total reduced operating profits by 3 percentage points.

So net-net I think we continue to deliver underlying top and bottom line results well in line with our long-term algorithm, while continuing to invest in the business to sustain our growth going forward in the marketplace.

Let me now take a minute to review some of the key factors as I look at the quarter impacting our business results, starting with our snacks business. Snacks volume was up 7% in the third quarter, largely reflecting an average growth rate of over 10% in all of our countries excluding the big three -- Sabritas, Walkers and Gamesa. This broad-based growth continues to be fueled by outstanding innovation and marketing activity and strength in emerging markets. For instance, in Saudi Arabia, the national launch of Doritos is helping that business grow over 30%. In China, Lay's was voted China's favorite salty snack brand for the seventh year in a row.

As we grow, we're also gaining market share. Our total system volume share was up almost 1 percentage point in the most recent trimester.

As it relates to the big three businesses, starting with Sabritas, at Sabritas we took pricing at the end of last year as you'll recall from our previous calls, to offset significant expected inflation. This resulted in the modest volume declines that we expected and planned for, but it also enabled us to achieve the expected positive revenue growth and profit flow through, in line with our expectations. Recent innovation and promotions like Ruffles Extra Hot and [inaudible - Spanish] continue to provide excitement to consumers and have driven a 1 point increase the in our market share in Mexico. So net-net, Sabritas is right in line with our expectations for the quarter as well as year-to-date.

At Walkers, volume was down low single-digits in the quarter. Having said that, we did continue to gain market share in all of our key accounts. However, this was more than offset by some category softness, in part I think reflecting the poor summer weather in the United Kingdom, as well as some pricing pressure in the non-traditional channels.

Having said that, I am confident that we've got the right plans in place to reignite growth going forward. For instance, to fuel demand we're launching Sunbites in the fourth quarter, which is our United Kingdom version of the successful U.S. SunChips brand that continues to go from strength to strength in John's business in North America. On Crisps, our advertising is going to focus on something called the great British potato, a campaign that will remind consumers of the local and wholesome goodness of their Crisps and the fact they're all grown in the United Kingdom.

In the marketplace, we'll refine our sales execution and our net revenue realization processes to ensure that we win across all of our channels. We'll couple that with continued tight cost control and drives for additional productivity.

In Gamesa, we had double-digit volume in revenue performance, led by the continued success of our high end product lineup, and a very successful [inaudible – foreign language] promotion. Our biscuit market share was up 1.3 percentage points and I'm very proud of the team there.

At the same time however, Gamesa too faced very, very significant levels of wheat and cooking oil and shortening inflation. In order to successfully manage those cost increases, Gamesa took pricing actions in both August and September. So looking ahead at Gamesa, I do expect a bit more balance between volume and revenue to drive our operating profit growth.

Turning to our beverages portfolio, volume for the quarter was up a very solid 8%, led by double-digit growth in key emerging markets like China, Russia, Pakistan and the Middle East. Carbonated soft drinks grew 8%, led by terrific growth from Mountain Dew, 7-Up and Mirinda; all of our flavor portfolio, in fact. Non-carbs were also up double-digits, driven by 40% growth in our Lipton ready-to-drink teas.

Great innovation is at the center of all of that performance. Our product 7-Up H20 continues to do extremely well as it gains traction in both existing Latin American markets like Argentina and Brazil, as well as new markets such as Ireland and Vietnam.

In China, we had tremendous excitement by the Pepsi Creative Challenge 2 Face On the Can where we had 2.5 million photos submitted for 20 spots on a Team China commemorative Pepsi can, and where we had, through the web, 140 million votes cast to determine the winners. This is truly what we call 360-degree marketing at its very best, and I'm sure you've seen a bit of the press we've got in celebrating Team China with yes, a red Pepsi can.

Net-net the fundamental performance of our international portfolio continues to be very strong.

Let me make just a couple of comments on acquisitions. First in August, as you know, in partnership with our bottler Pepsi Americas we closed on the purchase of an 80% stake in Sandora, the leading liquid refreshment beverage and juice company in the Ukraine. In September we announced the expansion of two very successful partnerships. We added 11 countries, especially in Western Europe, to our existing international Pepsi-Lipton joint venture, a truly global partnership focused on the world's number 1 brand of tea in the fastest growing ready-to-drink tea segment.

Second, we extended our coffee partnership with Starbucks to international markets, bringing together the great Starbucks brand and coffee know how with PI's beverage experience and distribution capabilities. Our first market for entry with Starbucks is going to be China with Frappucino.

Recently, we announced the acquisition of Comercio de Doces Lucky, a Brazilian snack company, which will add a couple of well-recognized brands --a wheat brand and an extruded brand -- as well as manufacturing capacity in strength and distribution to the lower end consumers in Brazil. It will fit brilliantly with our Brazilian snacks business.

Finally on the sustainability front, I'm extremely proud that UNICEF recently selected PepsiCo Exnora International zero waste management project in India as a model project and a center for international learnings in the area of urban solid waste management. We started this partnership with Exnora International, an environmental NGO, in 2005.

So in summary for PI, our top and bottom line performance was strong and broad-based across our geographies, snacks and beverages both. Our businesses are executing well and are doing a great job managing input cost headwinds. Recent tuck-in acquisitions are all on track, meeting our expectations and we're bringing new product opportunities to our portfolios. Our sustainability and corporate social responsibility agenda continues to move forward in all of our markets.

With that, let me turn the call over to Richard.

Richard Goodman

Thanks, Mike and good morning, everyone. As you saw in our release, we delivered a strong quarter with revenue up 11%, division operating profits up 10%, and core earnings per share increasing 11%. This brings our year-to-date growth to 10% revenue, 10% division operating profit and 14% core earnings per share. Our Q3 line of business operating margin was slightly lower than last year's on a reported basis. However, excluding the compression from M&A activity that Mike White just talked about, PepsiCo's overall LOB margin improved slightly.

What I would like to do now is to cover our corporate costs, period taxes and cash flow and then review our balance of year outlook.

For the quarter, corporate departmental expenses were up slightly, in line with inflation. We did see a $28 million negative swing in mark-to-market commodity hedges which, as expected, reversed the gains we had experienced in the first half of the year. Finally, the combination of deferred compensation and our hedges against that compensation exposure basically netted to zero, but we're required to report the deferred compensation upside in corporate unallocated and the corresponding hedge downside below the line in interest income. That compensation hedge downside actually accounted for about two-thirds of the increase in net interest expense. The rest of the increase largely reflected higher net debt as a result of acquisitions.

Bottler equity income was up $14 million in total on higher equity income pickup, offset in part by slightly lower gains on the sale of PBG shares.

For the quarter, our core tax rate was 27.4%, about 40 basis points higher than prior year, but still slightly better than we had originally forecast, largely reflecting timing between Q3 and Q4 tax items.

Lastly, our weighted average diluted share counts decreased 2.2% as a result of the stepped up share repurchase program authorized by our Board of Directors earlier in the year.

In total then, below the line items provided 1 point of leverage from LOB to core EPS, driven primarily by the lower share count and partially offset by the mark-to-market losses and the slightly higher effective tax rate.

Moving on to cash flow, year-to-date cash from operating activities is trending a little better than our $7 billion guidance for the full year, and our capital expenditure forecast remains consistent with our full year guidance of $2.6 billion. The net of these two, what we call management operating cash flow, is expected to be slightly ahead of guidance and to increase about 10% versus 2006.

We have returned $4.7 billion to shareholders this year, $1.6 billion in dividends and $3.1 billion in share repurchases. That's up $1.2 billion or 34% versus prior year. We expect cash to shareholders to be up this percentage for the full year as well, reflecting both higher share buybacks and the 25% increase in dividends we announced in May.

I'll turn now to our balance of year outlook. We expect our operating divisions to continue their solid performance in this fourth quarter, but we will also be reinvesting back in the business. In addition, we are now expecting a higher full year tax rate as a result of recently announced changes in Mexico's tax legislation. We're still reviewing the implications, but in addition to a higher effective tax rate when the legislation takes effect in 2008, there is a FAS 109 impact in 2007 related to the loss of certain deferred tax benefits.

Our preliminary estimate is that our full year 2007 core tax rate will probably be up to 40 basis points higher than the 27.3% we had previously communicated. That tax downside is why even with the strong Q3 results, we are simply maintaining our full year core earnings guidance of at least $3.35 per share.

Our core Q3 results and the core full year guidance exclude the impact of the conclusion of an international tax audit which resulted in a Q3 tax gain of $115 million, or about $0.07 a share.

In our full year core guidance we are also excluding the impact of certain Q4 restructuring actions, some of which we have recently approved and some of which are in process for which we expect to take charges in Q4 of around $0.03 a share. These relate to plant closings and to the rationalization of production lines in both our international and domestic businesses, all done to drive further productivity in 2008 and beyond.

In total then, very good results in Q3 which put us on track for core EPS growth of about 12% for 2007.

Before I turn the call back to Indra for her closing remarks, I would like to clarify the facts regarding the size of our business with Wal-Mart, our largest customer. An article in The Wall Street Journal last week included a chart showing PepsiCo's North American business with Wal-Mart as a percentage of revenues from 2003 to 2006. The basis for the chart was the disclosures that we made in the non-financial section of our 10-K filings relating to the concentration of business transacted with a particular customer.

Over the past several years, we have identified Wal-Mart as our largest retail customer worldwide and one that represents over 10% of our North American revenues. As you know, Wal-Mart in North America operates in both the mass channel with its Wal-Mart stores and in the club channel with Sam's. In our 2003 and 2004 filings, the percentage of sales that we reported for Wal-Mart included the stores in both channels. For 2005, however, we determined that it would with more appropriate to separate the segments and we therefore based our 2005 and 2006 concentration disclosures solely on the Wal-Mart format.

We did not note the change in methodology since we weren't analyzing year-over-year trends and since there is no requirement to show time series data in this section of the 10-K. The chart that you are now seeing on this webcast provides the facts over the 2003 to 2006 period. The first column shows the percentages just for Wal-Mart formats and the second column shows the percentages for Sam's Club.

As you can see, the Wal-Mart format increased as a percentage of PepsiCo's North American revenue every year from 2003 to 2006. That's in column 1. Sam's in column 2 also increased over this period; and indeed in every year as well, if you look at the unrounded numbers.

So in summary, I hope and trust that this clarifies the matter. Now let me turn it back to Indra.

Indra Nooyi

Thank you, Richard. Let me sum up by saying that we are very pleased with the company's performance for the third quarter and year-to-date. The momentum for the business is very strong. We fully expect it to continue going to the fourth quarter.

Our innovation and deal pipeline remain robust and we continue to make selective investments in the business and continue to show, with the advances in our sustainability and corporate social responsibility agenda, that performance and purpose can not only operate side-by-side, but actually unleash the creative talents of our 168,000 associates around the world.

With that, operator we are glad to open the line for questions.

Question-and-Answer Session

Operator

Your first question is from Bill Pecoriello - Morgan Stanley.

Bill Pecoriello - Morgan Stanley

Given the commodity outlook that you describe looking out into '08, can you give us some more color on how you're thinking about the various levers you have to offset this? Do you have an opportunity to accelerate productivity initiatives in PBNA or FLNA or International? I know you've had ongoing programs in those divisions for many years but any more opportunity to accelerate efficiencies there?

In terms of taking more price, you've seen some volume impact as you've taken price at Sabritas; Mike mentioned Gamesa. How are you thinking about those various levers looking into '08?

Indra Nooyi

Bill, as I said in my script, we're looking at all the levers: productivity, mix management, pricing. We're looking at all of these levers; for each product line, for each country we're reviewing what can be done to offset commodity inflation. I don't think it's prudent to go to that level of detail on this call, but rest assured there's no one lever that will be deployed, it will be a mix of all three levers.

Operator

Your next question comes from Lauren Torres - HSBC.

Lauren Torres - HSBC

With your recent announcement that enables Pepsi bottlers to distribute G2 and the Propel line, I was just wondering at this point if there is now a greater potential to transfer any of your existing warehouse delivery of Gatorade to the bottlers? As a result of this announcement, are you thinking a little bit differently about this brand?

John Compton

We see the opportunity to use the bottling system in the true up and down the street segment, in the C&G segment to launch the new G2 business and to transfer the entire Propel system over. We want to learn from this launch and see the benefits of DSD. We clearly know and have seen the benefits of our warehouse system over the past five years, so we're eager to see how the DSD system does with both G2 and Propel.

Indra Nooyi

If I could add to what John said, Gatorade to the warehouse is doing exceedingly well in large format. If we were to transfer to DSD and take on the additional costs of DSD we would have to get a lift in Gatorade that is extraordinary to make it work at DSD, and we don't see that kind of lift happening in large format because we're already well developed in large format. I see limited potential to move core Gatorade to the bottling system.

Operator

Your next question is from Christine Farkas - Merrill Lynch.

Christine Farkas - Merrill Lynch

John, I'm wondering if you could comment on Frito-Lay. The volume growth there was just a little bit below average. I'm wondering if the bulk of that is due to Lay's weakness or was there particular channel softness?

Indra, I'm curious to have your comments: if there is an economic slowdown, what would you be concerned with? Would it be certain product slow down or certain channel softness? Thank you.

John Compton

Yes, in the quarter, we probably should have noted this in the script and I'm glad you asked the question. Frito-Lay's volume growth in the quarter was around 2%. If you look at it on a year-to-date basis, we're around 3%. There was about a 1 point fall-off in volume growth. That's all attributed to a Fritos and Cheetos promotional event that we did last year in Q3 that we chose not to do again this year in Q3. That one event was worth about 1 point of volume growth if the quarter.

Going forward, we see this business around the 2.5% to 3% volume growth business, and I think you'll see that continue in the future.

Indra Nooyi

When it comes to the economic slowdown issue, Christine, it's mostly specific channel slowdown and really how people might shop in terms of premium products versus value products and what opportunities we may have to push premium products and what kind of pricing strategies we have to deploy on products that are sold in all channels. That is what requires careful thinking.

If you go back to Bill's question on the commodity outlook, we are in an inflationary environment. In an economic outlook, which guesses are all over the place, we just have to be very judicious in deploying all of the levers and remain very flexible and agile so that we can actually flex with the times as next year evolves.

Operator

Your next question comes from Bonnie Herzog - Citigroup.

Bonnie Herzog - Citigroup

I had a question just in terms of your global marketing spending efforts. I'm curious, are you spending enough, do you feel? As a percentage of sales, should we expect the amount that you're currently spending to increase in the future and possibly shift in terms of where the spending is allocated?

Mike White

Bonnie, certainly there's been an increase in our marketing spending this year and I expect that to continue, especially in emerging markets. I can't say that in the developed countries on either snacks or beverages that I see a material change, when you think about it as a percent of sales. I mean, obviously we continue to grow it in line with revenue in those kinds of markets, but I think we're at about the right level.

We're working hard to drive productivity within the marketing line. I would say probably the bigger news is the shift within our A&M spending towards more events linking in the web, like the China promotion that I mentioned where we had 140 million votes on the web for these photos of individual consumers in China.

I think that kind of linkage of advertising, packaging and the web, what I call 360-degree marketing, is much more of the news, if you will, in the way we're marketing to consumers. Then yes, I would say we certainly expect it to continue to be an intense marketing environment in key emerging markets as it has been.

John Compton

Bonnie, on the North American side, clearly already this year we've invested in A&M in the Frito-Lay North American business. In the quarter, again, A&M grew double-digit, faster than the revenue growth and it's consistent with the year-to-date performance.

In the beverage business, really the only place where our A&M spending has declined is in the Tropicana brand as we were trying to overcome the higher cost of oranges. You will see us as we launch G2 and Propel and Mountain Dew AMP support those brands in big ways with increased marketing support going forward.

Operator

Your next question comes from Judy Hong - Goldman Sachs.

Judy Hong - Goldman Sachs

I just had a couple of financial questions. Richard, in terms of the tax rate, your full year guidance implies that in the fourth quarter we may see a 30% plus kind of tax rate. Is that something that we could be looking at in 2008 going forward? Is the number really close to a 27.7% kind of number going forward?

Richard Goodman

Yes, you did the right squeeze. In Q4 it will be a tax rate above 30%. That's really a FIN 48 impact and on a go-forward basis, I would expect the tax rate to be in the high 27s, so about similar to where we are this year at the 27.7%.

Judy Hong - Goldman Sachs

Secondly, just in terms of your guidance for 2008, 10% plus EPS growth, does that assume similar level of the gain from sale of PBG stock in 2008 as well?

Richard Goodman

Yes. Right now that's assuming that, although we haven't completed our entire planning cycle, but clearly we've been selling down our share in our anchor bottlers down to IPO levels. They continue to buy back their shares so we should continue to see share sales going forward, as well.

Operator

Your next question comes from Ann Gurkin - Davenport.

Ann Gurkin - Davenport

I wonder if we could spend a little time on Eastern Europe and your outlook for that market, and the opportunities to cross sell your brands, whether through the recent acquisition or perhaps CSD or snacks in those markets?

Mike White

Eastern Europe and Russia both have been really dynamic growth markets for us and I expect that to continue. For instance on the snack side, even small countries like Romania have just been on fire in Eastern Europe. We're working on strategies to expand our presence in the Balkans, as well and our Russia business continues very strong. Our Poland business in snacks is doing very well. We are leveraging, for instance, PAS in Czech to distribute snacks in conjunction with their bottling presence there.

Certainly we have some plans, I think it's maybe a little premature for me to talk about for the Ukraine. Obviously, getting a big operating infrastructure there gives us a distribution platform that we did not have before to think about for snacks, and who knows, perhaps to even strengthen our CSD business in the Ukraine.

Certainly, for sure we continue to look at Eastern Europe. As I look at my Europe business, Eastern Europe and Russia continue to be the key growth engine for that business. I certainly expect us to continue power of one type initiatives which aren't really new for PI. We laid that theme out four years ago and continue to work for opportunities to leverage it and I think there are still those kinds of opportunities for sure in Eastern Europe, as well.

Ann Gurkin - Davenport

Great. Switching back to the earnings outlook for '08, does that include a level of concentrate price increase in the U.S. like we saw in 2007?

Indra Nooyi

We have not finalized our concentrate price increasing plan as of yet.

Operator

Your next question comes from Brian Spillane - Banc of America Securities.

Brian Spillane - Banc of America Securities

A question on pricing power. If you look at what you've done this year in terms of raising prices on Gatorade in the U.S., Sabritas in Mexico, and I guess in other parts of the world where you've raised prices has the price elasticity or the demand elasticity been better or worse than you anticipated is there any change in your thinking on pricing as you look forward relative to based on what your experience was this year?

Indra Nooyi

From my perspective, I think in pretty much in every country the elasticity was exactly what we expected. John, Mike, if you want to add something on pricing?

John Compton

As you've seen, year-to-date our Gatorade price in the measured channels is up about 2.5% year over year. I think that's the elasticity of the business. I think that fits our model pretty well. Our primary competitor though in that segment declined their prices 4%. I don't think we expected that coming into the year. As we said on the last call, our pricing on Gatorade that we took this year will carry us forward into 2008.

Mike White

I think in International I would say the same thing. Sabritas is just bang on all of the modeling we did last fall when we took the pricing and I haven't seen a change in any other markets. Certainly, we're gaining market share in those markets where we took pricing, so certainly in terms of the competitive game, I don't think pricing has put us at a disadvantage. I think certainly as consumers see broad inflation across the whole grocery store, we'll have to see how that plays out next year. Certainly from a snacks and a beverage standpoint, I can't say that I've seen any new pattern from an elasticity standpoint that would change my thinking about how we're planning for next year.

Brian Spillane - Banc of America Securities

Mike, just as on a rough basis, what percentage of your business did you actually take rate increases this year?

Indra Nooyi

That's a tough number to provide.

Mike White

Tough number to provide, frankly. I really couldn't tell you that. Every country has got different inflation levels. In Russia, you're talking about 8% inflation in the economy. It's quite different across the system. In International in general we have had probably more experience with pricing consistently, not just this year, but frankly, over the last five years than perhaps the U.S. just because of the macro economic environments you deal with in emerging markets.

Operator

Your next question comes from Bill Leach – Neuberger Berman.

Bill Leach - Neuberger Berman

I was just wondering if you could give us the PBG capital gain numbers, specifically? Also PBG had a $31 million after tax extraordinary gain in the quarter. How did you account for that?

Richard Goodman

I'll take that. We picked up our share of the $31 million in our equity income and that increased our equity income by about $10 million in the quarter.

Bill Leach - Neuberger Berman

Could you give us the capital gain in the quarter?

Richard Goodman

I think we had a gain of between $55 million and $60 million on the sale of the PBG shares.

Bill Leach - Neuberger Berman

Is that a fully taxable number or do you get a capital gains tax treatment on that?

Bill Leach - Neuberger Berman

Is that taxed at your normal rate or is that a 15% capital gains rate?

Richard Goodman

Yes, it's taxable at a normal rate.

Operator

Your next question comes from Matthew Riley - Morningstar.

Matthew Riley - Morningstar

I was wondering, has your long-term outlook towards commodity cost inflation changed at all over the past few quarters or past few years? I know we've heard out of some of the other large packaged food companies that they're thinking more that this is a long-term trend. I know PBG said they like the 2% to 3% price increase world, but are we going to be faced with a 4% to 5%?

Indra Nooyi

That is a tough one because a lot of it is supply/demand driven. Right now we're seeing escalation in prices of wheat, prices of heat because of energy cost, we're seeing escalation in prices of cooking oil. If a lot more supply comes onstream to outstrip the demand, we can see some equilibrium coming back to these prices. But at this point, it appears that worldwide demand seems to be outstripping the rate of these supplies coming onstream.

If you look at the foreseeable future, the next 18 - 24 months, it looks like structural inflation will continue in the commodity markets.

Operator

Your next question is from Alec Patterson - RCM.

Alec Patterson - RCM

Flat Earth, can you just give an update? How is it coming in line with expectations?

John Compton

Flat Earth has been a very stable business. It's not exactly the size that we had hoped coming into the course of the year. But the encouraging thing about the business is that the repeat rates have been very high, so it's all a matter of continuing to drive trial on the brand. The repeat rates are some of the highest that we've had in any of the Frito-Lay portfolios. We remain optimistic about Flat Earth. We have plans for new products to introduce behind Flat Earth for next year. I think it's a business that's going to continue to grow going forward.

Alec Patterson - RCM

Just on Gatorade, as you have seen the impact weather has had here and just the pricing that you have had to put in place versus the competition where there's been such a divergence this past year, has this caused you to recalibrate the elasticity around Gatorade in any way? Or are you still feeling that on an underlying basis, it's a good, high single-digit, nearly 10% type volume category?

John Compton

Alec, we've said long term our guidance in this business is high single-digit growth rates. We've exited, as I've said, the fourth quarter performing at that level and we're seeing that continue so far in the early part of the fourth quarter right now, and that's before G2 has hit the marketplace. There's been no shipments of G2 yet to the marketplace going forward.

We hit a very cool, rainy period for the last two weeks of July and the first two weeks of August. As you know, that's typically some of the hottest points in the year. That impacted our business.

Our competitor's pricing, frankly, almost is slightly irrelevant to us. We play our game. This is a great brand. We're here to serve the needs of athletes on a 24/7 basis and we keep our attention focused on innovation. This fortunately isn't a category that has private label. Our competitor's price point pretty much covers that off. There's been a historical price gap of 15% to 20%. That's where the brand has successfully lived before, and I think it can live there going forward.

Alec Patterson - RCM

So your elasticity models have not changed in that category?

John Compton

No.

Operator

Your next question comes from Robert van Brugge - Sanford Bernstein.

Robert van Brugge - Sanford Bernstein

A question about Tropicana. As orange juice futures have come down, would you expect this to start lowering your cost for this business going forward? Do you expect to have to pass this through to the retailers and consumers in the form of lower prices?

John Compton

I'm knocking on wood with my head this second, because we're not quite through the hurricane season, as you know. But so far, I think we would say based on what we know today, yes, we see our orange juice commodity costs coming down. We intend to spin back against the brand. This is a brand over the last two or three years that we've had to pull back on our advertising and our support to the brand.

As you know, it's the strongest brand in consumer packaged goods as it relates to standing for nutrition and health and wellness, so our number 1 priority will be to get the brand back on air and making it increasingly relevant with consumers for tomorrow.

Robert van Brugge - Sanford Bernstein

But would you expect retailers to be pushing for some kind of give back for the big price increases that you've taken this year?

John Compton

Robert, honestly, I don't think so because frankly, they have benefited from the price increases. So the profit per unit transactions have actually increased as the pricing has increased. The orange juice prices that we're seeing today in the marketplace are kind of where the category was in 1998 and 1999. So we're not well above where the business has been in the past. The prices did come down '03, '04 and '05, but the volume really didn't respond much from that. Se we'd rather spend back against the consumer.

Operator

Your next question comes from John Faucher – JP Morgan.

John Faucher - JP Morgan

Over the past couple years investors have given you guys a hard time for not buying back enough shares and you've had the option issue, when it's raised the shares outstanding. I guess this is the first quarter I think in about four years where we've seen the shares outstanding down more than 2%. Is this something that maybe we could continue to see going forward and does the better cash flow indicate a greater willingness to buy back shares?

Richard Goodman

As you know, John, we announced that we would increase the share buyback this year to about $4.3 billion from the $3 billion that we had the prior year. We would expect to be buying back at those kind of levels on a go-forward basis. Yes, we will get higher leverage off of those share buybacks than we had before because the number of shares will be decreasing at around the 2% level, at least in the short run.

John Faucher - JP Morgan

That's my question, Richard, which is can that continue beyond the short run? Yes, you announced a greater buyback, shorter term. But can we get one longer term?

Richard Goodman

We have authorization into 2010, I think, so yes, we should be seeing it at those kinds of levels over the next several years.

Indra Nooyi

John, the key thing is we generate very, very healthy cash flow. Basically, all the cash gets returned to the shareholders through dividends and share repurchases. We have a dividend policy that's published. You know exactly what it is. Everything beyond dividends goes back to share repurchase. That's how we deploy the cash and the share repurchase reflects how much cash flow is generated.

Operator

Your final question is from Kaumil Gajrawala - UBS.

Kaumil Gajrawala - UBS

On SAP, you're maybe a little further along on that now, if you have a grasp around cost savings. You did mention that the costs were a little higher than you expected internationally and maybe if you could give a little color on that?

Indra Nooyi

I think the SAP implementation so far, touch wood, is going flawlessly and I don't want to spook it, Kaumil, but so far all the releases, whether it's the U.S. or whether it's partially in Europe or whether it's in Mexico, I think the teams have done an excellent job putting SAP in.

Now in terms of the cost savings, it's hard to talk about cost savings now because the cost of putting in the SAP is still higher than the benefits we're getting out of SAP; that will be the case through 2008. In 2009 is when we start seeing some of the net benefits.

So at this point, the cost savings are flowing as we planned but the cost of putting in the SAP is still higher than the cost savings that are flowing through.

Kaumil Gajrawala - UBS

Switching gears a little bit, if you could talk a little bit about the global economic backdrop outside of the United States, is it still as favorable as you've been talking about in the past or are there some things that you're now maybe starting to worry about?

Mike White

I haven't seen any slowdown in the emerging markets. There are some folks that have tweaked their models a little bit for GDP growth in emerging markets, reflecting potential slowdown in the United States by maybe a half a point. But you're dealing with mid to high single-digit GDP growth rates, so a half a point is certainly not that material.

I haven't seen in our business any slowdown in our emerging market performance. It continues to really drive our portfolio. So from our own business standpoint, I don't think I could say that. I think that everything I've read and seen in talking to both economists in a number of countries as I've been traveling, I still am feeling very positive about the economic outlook for the emerging markets for next year.

I think you'll continue to see very solid growth out of those markets and I don't think that the U.S. housing thing is likely to have a significant impact on those emerging markets, from what I can tell.

Kaumil Gajrawala - UBS

The topic of food inflation, to what extent do you think on the food side, not on the other commodities, but on the food side to what extent do you think it's partially harvest related? We've had things like oranges. We've had a couple tough hurricane seasons, versus being just demand related with more demand out of Asia and such?

Indra Nooyi

Outside of oranges, it's been mostly demand driven. The corn for ethanol program has not particularly helped. Then you've got explosive demand for cooking oil and energy. All of these are driving the price of inputs up.

I think more and more people are shifting to wheat and oats and going into these healthy grains and it's driving up prices of those crops too, because there hasn't been a structural shift in the plantings to accommodate all of the demand. So that's what you're seeing in the marketplace.

It appears there are no more questions. I just want to thank all of you for your time and attention today, and your continued interest in PepsiCo. I look forward to speaking with you soon. Thank you.

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Source: PepsiCo Q3 2007 Earnings Call Transcript
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